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Part 2 of 2 - Click here for Part 1

Recently, we posted a blog that explored the return of participation provisions in venture capital deals as the market turns from entrepreneur- to investor-friendly (Liquidation Preferences: The Reality Behind the Zone of Indifference, Paul Jones, Tiara Brown, Kam Faines (michaelbest.com)).  We reviewed both full participation and capped participation, noting that both appeal to investors by providing some downside protection (boosted returns) in “sideways” exits – that is, exits where the returns are positive, but only marginally so. At the same time, participation’s negative impact on entrepreneurs was less significant in rosier exit scenarios.

Capped participation is positioned as the middle ground on the participation versus non-participation continuum.  Capped participation gives the investor a choice to either (a) take their pro-rata share of the proceeds, or (b) receive both their base preference (their actual investment) plus pro rata participation in the distribution of the remaining proceeds until the investor has received an amount up to some multiple (e.g. 2x or 3x etc.) of their base preference.

At first glance, capped participation seems like a reasonable alternative to full participation and non-participation options.  Digging deeper, though, there is a problem: Regardless of the cap value, capped participation creates a range of exit proceed values where the investor is indifferent to how much the company receives in an exit transaction.  In the so-called “zone of indifference” the interests of the investors and the common shareholders diverge, as all the marginal proceeds in the zone accrue to the common shareholders.  That divergence of interests can bite the common shareholders.

Consider a scenario where Acme Ventures invests $1 million in Newco and owns 40% of Newco on an as-converted basis.  With or without any form of participation, in these facts Acme would be entitled to a base preference of $1 million.  Table 1 below shows the distribution of exit proceeds over a range of values with non-participating preferred stock.  Note that at exit proceeds below $2,500,000 – the post-money valuation of the Company in our example, where Acme receives a 40% ownership interest for its $1 million investment – Acme will choose to take its $1 million preference rather than convert.  Note that at proceeds of $1 to $2.5 million Acme has no positive return on its $1 million while the common holders get all of the marginal proceeds above $1 million to $2.5 million.  Finally, note that when exit proceeds exceed $2.5 million, Acme will forgo its $1 million preference and take its pro rata share.
 

Table 2 below illustrates how the distribution of exit proceeds over the same range would play out if we assume Acme has fully participating preferred stock.  A few things to note.  First, all the exit proceeds accrue to Acme up to the amount of Acme’s investment of $1 million.  The classic example of “last money in, first money out” thinking.  Second, the relative advantage (to Acme) and disadvantage (to the Common) is greater at lower exit proceeds: by the time you get to a “home run” exit ($100 million in this case) the “extra” proceeds to Acme are almost a rounding error.  Finally, there is no exit proceeds scenario where any marginal dollars that the Company could squeeze out of the buyer would not benefit both Acme and the Common.
 

Table 3 below shows the exit proceeds distribution over a range of values, with a 3x cap on participation.   Again, some key things to note.  First, there is a yellow-highlighted “zone of indifference” in the exit proceeds between $6 million and $7.5 million where Acme has no interest in haggling about the price of the exit transaction because all the marginal proceeds above $6 million and below $7.5 million will go to the common shareholders.  That divergence of interest won’t matter if the exit is clearly going to be outside of that range.  But it could matter a lot if it is inside that range.  Second, the flip side of the zone of indifference problem – the silver lining – is that it eliminates the benefit of full participation to Acme once the exit proceeds exceed the zone of indifference, and the interests of Acme and the Common in negotiating a higher price re-align.
 

Now let’s consider a different compromise between no participation and full participation, one that eliminates the zone of indifference inherent in capped participation, and also gets rid of Acme’s participation bonus at higher exit proceeds levels.  We call it “partial participation” and the concept is straight forward: give Acme a fractional portion of its full participation bonus.  So, for example, if as in our previous example the participation bonus is 40% (Acme’s pro rata share of ownership) partial participation of 50% would reduce that bonus by ½, to 20%.

Table 4 (below) models partial participation over the same range of exit proceeds as tables 1-3.  The yellow highlighted row is the crossover point.  This is the point where Acme’s election to exercise its partial participation right (50% in this case) will give them access to no more than the proceeds it would have received if it chose not to exercise it.  Above the crossover point, Acme will always choose to forgo exercising the participation right (thus the bold numbers shifting from the “Investor 50% Part” column to the “Investor no Part” column).  Note that the zone of Indifference problem that we saw in capped participation is not an issue when partial participation is utilized.  Unlike full participation, partial participation models do not grant a participation bonus to Acme above the crossover point.
 

In conclusion, based on all of the above, partial participation is a superior compromise to capped participation, no participation, or full participation, for the following reasons:
 

1. It is more of a compromise.  That is, it offers investors less – but not zero – downside protection at any given lower exit value.  Very little less at 99% partial participation, and a whole lot less at 1% partial participation.  If a compromise between full and non-participation is the objective, that would seem the best way to construct it;
    
2. It eliminates the zone of indifference, so assuring that the investor and entrepreneur interests are aligned during any exit negotiation: both want a higher price at every possible range of prices; and
    
3. With partial participation the investor bonus goes away completely at some crossover valuation point.  So, while the investor gets some of the downside protection of full participation,  as the exit value rises, the bonus disappears.  There is no upside bonus at all for investors after the crossover point– which is superior to leaving investors with any bonus at all in the upside exit.

Some further thoughts.  Table 5 (below) directly compares the returns to Acme in the above hypothetical with no participation, full participation, capped participation (at 3x) and partial participation (at 50%).  The blue highlights indicate the crossover point, where Acme’s election for 50% partial participation preferred would make it indifferent to exercising its partial participation right or just converting to common stock.  Above that crossover point, Acme is likely to always choose to convert to common stock.  The yellow highlights indicate the zone of indifference.  Finally, the green highlights illustrate that: above the zone of indifference the payout for capped participation matches that where the investor declines participation and converts instead.
 

One reaction to Table 5 is that partial participation – at 50% - significantly reduces the participation bonus to a value below that of capped participation.  But that, we assert, is the idea of a true compromise between no participation and full participation.  If you want a different compromise pick a different fraction.  At 99% the “compromise” would be miniscule for the investor, while at 1% it would be enormous.  Similarly, you can adjust capped participation up or down from 3x.

Additionally, consider partial participation where the percentage is greater than 100%.  This results in a boost to both the downside protection and the upside participation for the investor.  In effect, you undercut the effective valuation below the “headline” number.  That could be employed as a clever (possibly devious) way to avoid reporting a down round, and instead keeping a “flat” (or possibly “up”) round headline.  At a partial participation fraction of 200% the investors capture an enormous piece of the up side, even at exit proceeds of $100 million (as you see in our example).  See Table 6 (below) for a comparison of full participation (in essence, partial participation at 100%) and partial participation set at 200%.
 

This table 6 shows that Acme, at 200% participation, is in effect getting a bit more than 80% of the exit proceeds for its 40% ownership stake.  From the investor’s perspective: what started out as discussion of participation around boosting returns for a range of sideways exits has morphed into a method of boosting returns across the full range of exit outcomes – except, without making a headline of it.

We’re curious to see if what our readers think about all this – and if any of them will be thinking about a partial participation compromise if/when full participation crops up in a term sheet.  We’ve attached a spreadsheet model here if you want to explore alternative hypotheticals and variables for yourself.